If interest rates rise in the UK because inflation is high while growth is very low or negative - conditions often called stagflation - then investors need to own “physical assets”, according to James Sullivan, head of partnerships at Tyndall Investment Management.
Central banks are presently grappling with the dilemma that while inflation expectations are rising fast, growth expectations are falling.
Traditionally, central banks lift rates to curb inflation, or cut rates to boost growth. Choosing which issue to prioritise is at the centre of the present interest rate debate, with many policymakers taking the view that the present inflationary spike is transitory in nature.
Sullivan said if the present inflationary pressure does lead to stagflation, “then that doesn’t do anyone any favours. What to own in that environment is likely to be physical assets rather than financial ones. However, that outcome aside, higher rates as a result of meaningful growth and productivity coming back into the system, enhanced somewhat by a supply demand imbalance, should be the sweet spot for equity income.
"Companies that display greater levels of cyclicality, potentially buoyed by a steepening of the yield curve (financials), and have dividend cover ratios capable of sustaining greater pay-out ratios over the short and medium term, would be deemed appropriate bedfellows for such a macro environment.”
If the inflation and rate rises come as a result of more normal factors, such as strong economic growth, then Sullivan believes that, while the market is focused on a range of assets to deal with this scenario, he says the best option may be equity income shares, as many of those have traded at low valuations over the past decade.
Adam Avigdori, who jointly runs the BlackRock Income and Growth investment trust said: “Rising inflation has, understandably, led to a preoccupation with the likelihood of a rise in interest rates.
“For income investors, we would highlight the more positive picture we see, with cash generation improving and dividends payments recovering.
"Broadly speaking we've been surprised by how quickly dividends have come back with large contributions from the mining sector where several companies have been able to pay large special dividends. While dividends are not far off from pre-Covid levels as the majority of companies are paying dividends once more, we note the large contribution from special dividends that may not persist. We view the outlook for ordinary dividends for the UK market with optimism as most companies have emerged from the Covid crisis with appropriate dividend policies.”